Mapping Out Taxes for Personal Service Corporations

It’s bad enough that every corporation must pay income tax at rates reaching up to 35 percent (a portion of income may actually be taxed at a 39 percent rate — see chart at the bottom of this article). But the tax burden is even more onerous for corporations labeled as “personal service corporations.” In that case, the tax rate is a flat 35 percent.

Naturally, the determination of this tax status is often contested in the courts. In one case, the Tax Court said a corporation qualified as a personal service corporation even though its employees weren’t licensed professionals in the field.Thus, personal service corporations don’t benefit from the graduated rate structure that other corporations do. This anomaly in the tax law can cost some companies thousands of extra tax dollars.

Background: The tax law definition isn’t completely clear-cut, but a corporation is generally treated as a personal service corporation if it meets a “function” and an “ownership” test.

Function test: Substantially all of the activities involve the performance of services in a field of law, accounting, health, engineering, architecture, actuarial sciences, performing arts or consulting. For this purpose, “substantially all” means that 95 percent or more of time spent by employees is devoted to these services.

Ownership test: Substantially all of the stock is held, either directly or indirectly, by employees performing these services or retired employees who provided these services.

Ownership of 95 percent or more of the stock is considered to be “substantially all” ownership.

Facts of the case: In the case, Kraatz & Craig Surveying Inc. was engaged solely in land surveying. It did not employ any licensed engineers nor was it associated with any firm employing licensed engineers. The Tennessee firm did not dispute that it met the ownership test for being a personal service corporation. However, it argued it did not meet the function test because it was not engaged in any of the specified services.

The IRS contended that the land surveying constituted performance of engineering. It based its position on existing regulations that treat land surveying and mapping as engineering services. (Regulation 1.448-1T(e)(4)(i)) The surveying firm countered by saying that the regulation was invalid. It argued that the firm’s services would qualify as “engineering” under state law only if they were performed by licensed engineers.

Result: The Tax Court sided with the IRS. First, it upheld the regulation as being valid. In addition, the Court ruled that the determination of whether a corporation is a personal service corporation should be based on all the relevant facts and is not controlled by state law. Accordingly, the surveying firm was responsible for a tax deficiency of $9,762. (Kraatz & Craig Surveying, Inc., 134 TC No. 8)

Your CPA firm can analyze whether a business satisfies the definition of a personal service corporation and the most tax-effective way an entity should be structured.

Corporate Tax Rates for Non-Personal Services

Corporate taxable income over

Not over

Tax Rate

$0

$50,000

15%

50,000

75,000

25%

75,000

100,000

34%

100,000

335,000

39%

335,000

10,000,000

34%

10,000,000

15,000,000

35%

15,000,000

18,333,333

38%

18,333,333

–

35%

The impact for personal service corporations is especially acute at lower income levels. For instance, a personal service corporation with $100,000 of annual income pays $35,000 in tax in contrast to $22,250 for a regular C corporation — a difference of $12,750.